The worst-case scenario of the US debt crisis: if Trump orders a default!

As Trump renews his pursuit of the presidency, the issue of the US debt crisis is once again being discussed.

According to a report released by the Congressional Budget Office (CBO) in mid-June, the US federal debt is projected to reach 109% of GDP by 2028, and is expected to surge to 122% by 2034, which is 2.5 times the average GDP ratio over the past 50 years. The CBO estimates that 2024 will be a milestone year when interest payments on US debt exceed defense spending.

However, according to Nomura, the CBO's forecast is still optimistic.

Nomura analysts Rob Subbaraman and Yiru Chen released a report on Tuesday stating that due to uncertainties in fiscal consolidation, inflation, and economic growth, the US faces a very serious fiscal problem, and government debt has embarked on an unsustainable path.

When analyzing the future of US finances, Nomura considered three scenarios: Good, Bad, and Ugly.

The analysis points out that in extreme cases, if Trump is re-elected as US president and stops debt repayment, the credibility of the US dollar will be damaged, leading investors to demand higher risk premiums on US debt, which could sharply increase government interest payments. Without large-scale fiscal consolidation, the Federal Reserve loses its monetary policy independence, the government implements strict financial controls in an attempt to push real US bond yields deeply negative to liquidate federal debt.

Good: Economic Golden Age, Increased Tax Revenue, Reduced Deficit

In the best-case scenario, Nomura believes that with the push of the Gen-AI revolution, the US economy may enter a period of strong growth and low inflation.

With increased incomes for businesses and individuals, government tax revenues will also increase, helping to reduce the budget deficit.

At the same time, the government will optimize the debt structure and reduce debt costs by taking advantage of low interest rates in a low inflation environment.

In this scenario, Nomura believes that by the end of 2025, the 10-year Treasury yield will fall to 4.2%, and the 2-year yield to 3.7%.

However, this scenario seems more and more like a distant dream. Instead, the US is more likely to face the latter two more severe scenarios.

Bad: High Inflation, Economic Downturn, Declining Government Revenue, Worsening Deficit

In the bad scenario, Nomura states that inflation remains high, and the Federal Reserve's adjustments to interest rates are far less proactive than market expectations.

This will lead to continued economic stagnation, with the US government making almost no progress in reducing the budget deficit. The Treasury Department will face challenges in refinancing a large amount of short-term debt coming due, while private investors will demand higher risk premiums for purchasing new long-term government bonds This will form a vicious cycle:

Government borrowing costs rise → Net interest expenses increase → Private investment is squeezed → Economic growth slows down → Government revenue decreases → Budget deficit continues to expand → Public debt ratio rises on a steeper trajectory than CBO predicts.

Ugly: Debt crisis strikes, Trump may halt debt repayment in extreme cases

As for the ugly scenario, it could be catastrophic.

Nomura points out that in this scenario, the U.S. fiscal balance may reach a critical point - similar to the debt crises experienced by some emerging market countries. Private investors lose confidence in U.S. bonds, and the Treasury Department is unable to borrow at affordable rates, leading to a severe fiscal crisis.

And the trigger for all of this could be the U.S. presidential election.

Nomura states that whether it is market expectations for more fiscal stimulus triggered by Trump's re-election, or the loss of trust in U.S. institutions by foreign investors due to election result disputes, it could have a significant impact on the U.S.'s "excessive privilege."

The most extreme scenario is that Trump orders a halt to debt repayment.

Nomura mentioned a recent prediction by former International Monetary Fund senior policy advisor Barry Eichengreen: considering Trump's history of personal debt defaults, if he is re-elected as president, he may instruct the Treasury Secretary to suspend debt payments. This decision may not be opposed by Congress or the courts, as currently about one-third of U.S. government debt is held by foreigners.

A U.S. default would undoubtedly trigger severe turmoil in the international financial markets, and while "killing a thousand enemies," the U.S. would also harm itself by "three hundred."

Eichengreen recently wrote that U.S. institutions may not be as strong as they appear. If the U.S. chooses to suspend debt repayment, even if eventually revoked by Congress, the courts, or the next president, the credibility of the U.S. dollar would be damaged . This would lead to investors demanding a higher risk premium on U.S. bonds, potentially sharply increasing the government's interest payments.

He also stated that as the debt ratio rises, the federal government may need to cut discretionary spending, which could have a negative impact on economic growth.

For example, the chip bill and inflation reduction bill enacted in 2022 aim to stimulate economic growth by encouraging investment, but if the government needs to cut spending to address debt growth, the effectiveness of these measures may be limited.

Nomura further points out that without large-scale fiscal consolidation, the Federal Reserve would lose its monetary policy independence, the government would implement strict financial regulations in an attempt to push real U.S. bond yields deeply negative to liquidate federal debt.

Nomura predicts that in the ugly scenario, the U.S. bond yield curve may experience unprecedented compression, with the yield spread between 2-year and 10-year U.S. bonds potentially falling to the lowest levels in decades.

Future fiscal consolidation - a challenging task

In terms of future fiscal consolidation, the United States faces a series of challenges.

The report highlights challenges such as rising debt servicing costs, pressure from aging population on social security and healthcare expenditures, the impact of deglobalization on economic growth and tax revenue, increased defense spending due to national security concerns, costs of climate change adaptation, and structural issues in fiscal expenditure limiting the government's investment capacity in key areas In addition, factors such as election results, policy changes, and fluctuations in the international monetary environment have increased the complexity of fiscal restructuring